Category Archives: Market Commentary

In a complete reversal from 2017, 2018 saw the bull market in US large cap stocks almost come to a halt amid a return to volatility.

Equities set several records during the fourth quarter, and none of those records were good. Global equities, real estate, and commodities were all negative for 2018; the last time this happened was in 2008. December 2018 was one of the worst Decembers for US equities since the 1930s. Also, US small cap stocks officially ended its almost 10?year bull market in December 2018 by declining more than 20% from its August peak. The main thing that 2017 and 2018 have in common is that most asset classes moved in one direction—a pattern that’s not seen in a typical year. In 2017, markets seemed to overlook the looming economic challenges. But markets finally reflected those challenges in their prices in 2018. While we don’t like the downturn, we are not alarmed by it.

Investing in foreign developed and emerging market stocks appears wise, despite their underperformance in 2018. Conflict with our international trading partners continued to be a big factor in foreign stock underperformance this year. Also, global central banks have begun mirroring the US Federal Reserve policy of tighter money conditions. Both have weighed on equity prices across the globe. However, foreign developed and emerging market stocks held up better than US stocks during the fourth quarter. Additionally, after the dollar’s strong performance the past several years, the inflated U.S. budget deficit and the overvaluation we see in U.S. stocks, we believe the U.S. dollar is a risk factor that investors would be wise to avoid. Our allocation to foreign stocks provides our portfolios with protection and diversification away from the U.S. dollar.

Here are the broad index returns through the Fourth Quarter of 2018*:

U.S. Large Cap Stocks

-4.4%

U.S. Aggregate Bonds

0.0%

Global Real Estate

-4.8%

U.S. Small Cap Stocks

-11.0%

International Bonds

-0.8%

Allocation 30%-50% Equity

-5.0%

Overseas Stocks

-13.8%

Commodities

-11.3%

Allocation 50%-70% Equity

-5.8%

Emerging Market Stocks

-14.6%

U.S. Real Estate

-5.8%

Allocation 70%-85% Equity

-7.9%

Economic Outlook

Many analysts are forecasting lower US GDP growth for 2019. The US economy is in the late stage of its expansion, ahead of Europe, the UK, and Japan, who are still in the middle stage of their expansions.Additionally, going forward, US corporate earnings will not have the bump from tax cuts as they did in 2018. However, one wildcard continues to be the Federal Reserve’s campaign of rising interest rates. Recent indications from Fed officials, including Chairman Jerome Powell, suggest that the Fed is now more flexible regarding future rate increases and could even take a pause if economic conditions warrant. Inflation is projected to remain tame and unemployment is expected to remain low. It truly is a mixed-bag regarding the US economy in 2019.

Headlines are now turning from the US to Overseas. Brexit (the withdrawal of the United Kingdom from the European Union on March 29th) has been getting much press lately. The worst-case scenario would be that the UK leaves the EU without the necessary treaties and agreements in place and the British start to experience economic hardships like higher inflation and unemployment. Although UK stocks only comprise about 1-3% of our portfolios, we will continue to monitor the situation and adjust, if necessary. Another headline that keeps popping up is the projected slowdown in global growth beginning in 2019. However, the most current forecasts by both the World Bank and The Conference Board predict a drop in World GDP of only 0.2% over the next two years; clearly not the earth-shattering decline the media trumpets. Despite the risks we see over the short term, we have high conviction that our investments in European and emerging-market stocks will earn significantly higher returns than U.S. stocks over the next five to 10 years.

Over the next year, the range of potential equity market outcomes is just as wide as it was going into 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet our clients’ longer-term return goals, which means successfully investing through multiple market cycles, not just the next 12 months.

Tax Planning – 5 Strategies for 2019

The first quarter is the time to begin tax planning for the year. Here are five things to remember for your 2018 tax return and to lower your taxes in 2019:

If you are over 70 ½ years old and taking minimum required distributions from your IRA, consider a qualified charitable distribution (QCD) for your charity and church giving. When you use the QCD to give your gifts you lower your adjusted gross income. If you performed a QCD in 2018, remember to remind your tax preparer that the contribution is NOT tax-deductible.

Prior to the changes introduced by the new tax law, allowable itemized deductions were subject to phase-out for taxpayers whose income exceeded certain thresholds. The new tax law abolishes this limitation on itemized deductions for tax years 2018-2025. This makes giving during years of high income even more powerful.

Starting in 2018, tax-free distributions from 529 plans can also be used to pay up to $10,000 of expenses per student per year for elementary and secondary schools. Alabama also provides a state income tax deduction for contributions to the state plan of up to $10,000.

It may be time for you to update your will. Because the tax laws significantly increased the amount that can be passed tax-free to your heirs, the provisions in your will may no longer apply. Check with your estate planning attorney to see if it makes sense for you to have an update.

Decide if this is the year to “bunch” your deductions. Remember that the standard deduction for couples will be $24,400 this year. In order to maximize the benefits of the higher deduction, alternate years of giving and deductible expenses to exceed the standard deduction every other year.

We truly appreciate the opportunity to work with you and look forward to talking with you again soon!

*U.S. Large Cap=S&P 500, U.S. Small Cap=Russell 2000, Overseas Stocks=MSCI EAFE, Emerging Market Stocks=MSCI Emerging Markets, U.S. Bonds=Barclays Aggregate Bond Index, International Bonds=FTSE WGBI, Commodities=Bloomberg Commodity, US Real Estate=MSCI US REIT, Global Real Estate=S&P Global REIT: Data Source: Morningstar®. Economic Data: Litman Gregory Analytics and Vanguard Investments. Allocations=Morningstar® U.S. Fund Allocation Categories: Data Source: Morningstar®. Tax Planning Data Source: KPMG 2019 Tax Planning Guide.Index returns are for illustrative purposes only and do not represent actual performance of any investment. Client returns will differ from the results shown. Index performance returns do not include any management fees, transaction costs or expenses. The performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate; thus an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than return data quoted herein. Indexes are unmanaged and one cannot invest directly in an index. Please review your allocation regularly and notify BFA immediately if your circumstances should change.

The US market was propelled by continued strong profit growth, thanks in large part to the Trump corporate tax cuts. S&P 500 operating earnings per share grew 27% year over year in the third quarter and a record-high 80% of S&P 500 companies reported earnings that beat the consensus expectation. The S&P 500 index hit a new all-time high in late September.

Emerging market stocks fell 1.0% and developed international equities had a slight gain of 1.4%. There are always multiple factors behind short-term market moves, but the intensifying trade conflict between the United States and China was an important one for foreign markets and specifically EM stocks in the third quarter. Another factor was the US dollar, which appreciated against other currencies again this quarter. This currency appreciation created a drag on foreign stock market returns for dollar-based investors.

In the bond markets, the yield on the 10-year Treasury rose to 3.05% at the end of the third quarter, flirting with a seven-year high. As such, the core bond index had a negative 0.5% return in September and was flat for the quarter.

Here are the broad index returns through the Third Quarter of 2018*:

U.S. Large Cap Stocks

10.5%

U.S. Aggregate Bonds

-1.6%

Allocation 30%-50% Equity

1.1%

U.S. Small Cap Stocks

11.5%

International Bonds

-3.6%

Allocation 50%-70% Equity

3.1%

Overseas Stocks

-1.4%

Commodities

11.8%

Allocation 70%-85% Equity

3.9%

Emerging Market Stocks

-7.7%

U.S. Real Estate

2.1%

Economic Outlook

The longer-term growth outlook remains intact for Emerging Market and US stocks.

Conditions in emerging markets still appear favorable. Given the negative headlines concerning emerging markets in recent months, there are several points worth highlighting based on additional research and analysis in this area. First, the prospect of an expanding trade war between the United States and China intensified in the third quarter and has caused investor sentiment to turn against emerging markets. Uncertainties remain, but logic suggests that a full-fledged trade war is unlikely since it’s in neither country’s interest. Second, a strong US dollar, as we’ve seen lately, lowers EM stock returns for US dollar–based investors and negatively impacts emerging markets with dollar-denominated debt. However, the US fiscal stimulus (tax cuts) implemented at a time when the economy is at or near full employment will likely cause fiscal deficits and debt levels to rise. This should be a longer-term headwind for the US dollar and a positive for EM stocks. Finally, the economic crises in Argentina and Turkey have made headlines. However, these economies and their financial markets are very small and the risk of contagion to other, more meaningful emerging markets is low. In contrast to the late 1990s EM crisis, most other EM countries’ fundamentals are healthier and their prospects positive.

The US market is a horse of a different color.

No one knows exactly when this record-longest and second-strongest US bull market will end. The fiscal stimulus from the tax cuts has goosed corporate earnings growth this year, but those benefits will fade soon. And as is often the case at turning points in financial markets, it is precisely because the recent cycle for US stocks has been so strong and market participants view the US as the best game in town, that the outlook for the next phase of the cycle is darkening. There are three things to anticipate: 1) S&P 500 earnings growth expectations are now exceedingly high and the US economy is operating at or near full capacity and full employment. These conditions are unsustainable and a negative for future stock returns. Strike one. 2) The tight labor market has finally translated into wage increases. History and economic theory suggest wages will continue to rise, negatively impacting corporate profit margins and earnings growth. Rising wages could also cause companies to raise prices, stoking inflation and forcing the Fed to tighten even more. Strike two. 3) The recent rise in the dollar is likely to be another headwind for US multinational corporate profits, as it was in 2015 when the dollar rose. Trade wars, if they continue to escalate, will also have a depressing effect on sales growth and margins—both are negative for earnings and stock prices. Strike three. So, US stocks are over-earning but still expected to grow earnings even faster than normal over the next year and are expensive based on the most reliable valuation metrics. That is not a recipe for good returns looking forward.

In times of unusual volatility, it is critically important to keep the longer-term perspective and diversification in mind. It is easy to be fooled by temporary divergence in the performance of the various asset classes, but a disciplined, fundamental approach will ultimately win in the end.

New Insurance Partner

BFA has established a partnership with a commission-free, low-cost insurance provider for our clients. By cutting commissions, this company can lower the costs of life and long-term care insurance as well as some annuity products. If you or anyone in your family has an insurance need, please let us know and we will be happy to help you access this low-cost provider.

We truly appreciate the opportunity to work with you and look forward to talking with you again soon!

The second quarter reinforces the random nature of short-term performance.

As we pause to reflect at the midpoint of the year, 2018 has served as another reminder to investors that over the short term, markets are driven by innumerable and often random factors that are impossible to consistently predict. In the first quarter, US stocks experienced their first major losses since 2016 and a return to more “normal” market volatility. Many market prognosticators speculated that this could indeed be the end of the nearly decade-long US bull market.

Fast-forward through three more eventful months and US stocks have been the net beneficiaries, gaining 3.4% on the back of a surging dollar while the rest of the world has slowed. The dollar’s 5% appreciation translated into a meaningful return headwind for dollar-based investors in foreign securities as foreign currencies depreciated against the dollar. Developed international stocks fell 1.8% and European stocks declined 1.6% for the quarter. Emerging market (EM) stocks fared the worst, dropping 9.6% in dollar terms.

In bond markets, the benchmark 10-year Treasury yield pierced the 3% level in May, hitting a seven-year high. Yields then fell back, ending the quarter at 2.85%. The core investment-grade bond index had a slight loss for the quarter and remains in negative territory for the year.

Here are the broad index returns through the Second Quarter of 2018*:

U.S. Large Cap Stocks

2.9%

U.S. Aggregate Bonds

-1.6%

Allocation 30%-50% Equity

-0.7%

U.S. Small Cap Stocks

7.7%

International Bonds

-6.0%

Allocation 50%-70% Equity

-0.1%

Overseas Stocks

-6.7%

Commodities

10.4%

Allocation 70%-85% Equity

0.4%

Emerging Market Stocks

–5.9%

U.S. Real Estate

1.4%

Economic Outlook

It was a difficult quarter for equity holdings, particularly in the emerging markets.

In 2016,as the global economy began firing on all cylinders for the first time since the financial crisis began, EM stocks surged, gaining 12% in 2016 and 32% last year. EM stocks then bolted out of the gates in 2018, with an additional 11% return through late January. Since then, however, these holdings have declined sharply, and returns are now in negative territory for the year. The selloff in EM stocks appears to have been driven by a combination of investor concerns about 1) a potential trade war with China, the European Union, Mexico, and Canada; 2) how EM economies will manage a deceleration in global growth outside the United States; and 3) a stronger US dollar coinciding with rising US interest rates and tightening Fed monetary policy.

These macro developments, specifically the risk of a US trade war with China and the rest of the world, are indeed risks to EM stocks in the shorter term. However, these are not new risks and are not likely to overwhelm the attractive fundamentals, valuations, and potential longer-term returns of EM stocks. Analysis suggests that emerging markets are fundamentally better placed today than in past cycles. The sector composition of EM indexes has changed meaningfully over the past decade, from traditional heavy-cyclical industries like materials and energy to more growth-oriented technology and consumer-driven sectors that are less sensitive to shifts in global growth.

It is understandable that fears of a global trade war are rattling financial markets.

Any resolution of the current trade tensions is a meaningful uncertainty—our relationship with China being the most fraught—with the potential to seriously disrupt the global economy at least over the shorter to medium term. President Trump’s unconventional negotiating approach adds an additional wildcard dimension.The process is likely prone to several more twists and turns before things become clear. It is in the best interest of both the United States and China to negotiate a resolution and prevent trade skirmishes from becoming an all-out trade war. However, the potential for a severely negative shorter-term shock to the global economy and risk assets (like stocks) can’t be dismissed. Even absent an actual trade war, the negative impact on business and consumer confidence from the uncertainty and fear of a trade war is a risk to the remaining longevity and strength of the current economic cycle.

Globally diversified portfolios are structured to perform well

Globally diversified portfolios are structured to perform well over the long term while providing resiliency across a range of potentially negative short-term scenarios.Should the current trade tensions resolve and the global economic recovery continue, outperformance should come from international and emerging market stock positions and flexible bond funds. Alternatively, should a bear market strike, “dry powder” in the form of lower-risk fixed-income and alternative investments should hold up much better than equities. This capital will be put to work aggressively following a market downturn by reallocating to equities at lower prices. The portfolios are built to weather the volatility.

We truly appreciate the opportunity to work with you and look forward to talking with you again soon!

Welcome back! Volatility returned to the financial markets this quarter. U.S. and overseas stocks surged in January, corrected sharply in early February and then rebounded into mid-March. They dipped again into quarter-end, buffeted by a potential trade war and a Facebook data scandal. But despite the volatility, they ended down only 0.7% and 1.5% respectively. Emerging-market stocks held true to their higher-volatility reputation. They shot up 11% to start the year, fell 12% during the mid-quarter correction but finished the quarter with a positive 1.4% return. Unfortunately, core bonds didn’t play their typical “safe-haven” role in the first quarter, since Treasury yields rose across the maturity curve. True to form, core bonds also posted a 1.5% loss.

Here are the broad index returns through the First Quarter of 2018*:

U.S. Large Cap Stocks

-0.7%

Emerging Market Stocks

1.4%

U.S. Small Cap Stocks

-0.1%

Commodities

2.2%

U.S. Real Estate

-5.9%

U.S. Aggregate Bonds

-1.5%

Overseas Stocks

-1.5%

International Bonds

-2.0%

Economic Outlook

There are two primary observations about the quarter’s rocky ride. First, the recent 400-day long S&P 500 rally, that occurred without a single 3% decline from its high, was not normal. It was the longest streak in 90 years of stock market history. Comparatively, stock market declines of 10% or more are normal and have occurred in over half of all calendar years since 1950. The market has simply returned to “normal.” Second, despite the dramatic news headlines and market volatility, the economic news that contributed to the recent selloff was that the economy might be getting a bit too strong and the tight labor market could finally translate into higher wage growth and broader inflationary pressures. Fundamentally, the U.S. and global economies still look solid. Global growth may no longer be accelerating, but it remains at above-trend levels and the likelihood of a recession over the next year or so still appears low.

Be prepared for another bear market. The Trump tax cuts and new fiscal spending bill will likely stimulate more spending, deficit-financed measures that are likely to be inflationary. As a result, monetary policy and overall financial conditions will gradually tighten to compensate for the rising inflation. Consistent with the historical pattern, economic activity and asset prices will probably decline and the U.S. economy will slide into a recession and a full-blown bear market, a 20%-plus decline in stock prices. We are not there yet, but it is coming.

What is the best defense? First, it is worth remembering that a five-year or longer time horizon is the basis for any reasonable expected-returns analysis. It is over those longer-term periods that valuation (i.e., what you pay for an investment relative to its future cash flows) is the most reliable predictor of returns. Over the shorter term, markets and economies are reliably unpredictable and are driven by innumerable and often random factors (i.e., noise). Because of this, in the investing world, we are often our own worst enemies. We tend to fall prey to short-term performance-chasing, our natural inclination to “do something,” emotional responses and other behaviors that hurt us as investors. The best defense is having a sound, fundamentally-grounded investment process (like ours) that will work for the long term and sticking with that process through periods of volatility. Second, this may be the appropriate time to consider your capacity (and patience) for a protracted bear market and larger stock declines. It is easy to forget the experience of negative returns during periods of extraordinary growth. Now may be a good time to reconsider your tolerance for volatility (risk) and manage within your boundaries. Of course, we are happy to help.

The bull market continued for another year. The summary below shows that just about everything gained in 2017, causing market indices to repeatedly soar to new heights. Larger-cap U.S. stocks gained 6.6% for the quarter and ended the year with a 21.7% total return. This was the ninth consecutive year of positive returns for the index—tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis. Foreign stock returns were even stronger than the U.S. market, with developed international markets gaining 25% and emerging market stocks up 37.3% for the year.

The broad driver of the market’s rise for the year was rebounding corporate earnings growth. Ned Davis Research analysis shows that, over the last 12 months, the United States saw earnings grow by 14%, Europe saw earnings grow by 25% and the U.K. local-currency earnings grew by 35%. Support for this jump in earnings resulted from solid economic data, synchronized global growth, modest inflation, and accommodative monetary policy. U.S. stocks got an additional catalyst in the fourth quarter with the passage of the Republican tax plan.

Here are the broad index returns through the Fourth Quarter of 2017*:

U.S. Large Cap Stocks

21.7%

Emerging Market Stocks

37.3%

U.S. Small Cap Stocks

14.7%

Commodities

1.7%

U.S. Real Estate

5.1%

U.S. Aggregate Bonds

3.5%

Overseas Stocks

25.0%

International Bonds

10.5%

Economic Outlook

As noted above, U.S. stocks were up for the year, driven in part by expectations of a historic corporate tax cut. It is likely that much of the benefit of tax decreases is already priced in based on consensus earnings estimates for the S&P 500. So, what do lower corporate tax rates mean for long-term earnings assumptions for the United States? The answer is not straightforward, as there are many variables to consider.

Politically, the tax cut was designed to provide an incentive for companies to hire and spend more. Some companies will increase hiring and boost pay as a token gesture but ultimately the pressure from shareholders will lead many companies to return much of the excess cash flow from tax savings to shareholders or capital owners, not employees.

U.S. Corporate earnings will probably see a boost in the short term (consensus seems to be around 10% in aggregate) with more benefit provided to smaller companies. Over the long term, however, the incremental margin benefit from lower taxes will likely be “competed” away. In the new tax plan, there’s an additional tax incentive for companies to pursue capital expenditures. This could increase economic activity and boost overall profits but may also result in an increase in inflation.

Political uncertainties notwithstanding, Europe continues its economic recovery. It is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20% in 2017. Emerging markets are experiencing a rebound in corporate earnings growth, and, importantly, are becoming less dependent on commodity-oriented sectors as technology and consumer sectors have assumed greater importance. Both overseas stocks and emerging market stocks appear poised to do well in the coming months.

The third quarter has a reputation as the worst seasonal period for stocks. This year, global stock markets rallied. Emerging-market stocks lead, climbing 8%, followed by European stocks, which gained 6.2%. More broadly, developed international stocks rose 5.5%. For the third consecutive quarter the U.S. dollar depreciated against foreign currencies, providing a boost for dollar-based investors.

In addition to great growth around the world, the U.S. market delivered strong returns in the third quarter, extending its winning streak to eight consecutive quarters. The S&P 500 Index closed at an all-time high after gaining 4.5%. Within the U.S. market, larger-cap growth stocks—technology stocks in particular—continued their year-to-date dominance over smaller-cap and value stocks.

Fixed-income markets and core investment-grade bonds inched up 0.7% for the quarter. The 10-year Treasury yield (which moves inversely to bond prices) ended the quarter flat, but this masked intra-quarter shifts. It bottomed in early September as fears over North Korea, hurricanes, and political events peaked. But the yield shot up at month-end, closing the quarter right about where it stood three months earlier.

Here are the broad index returns through the Third Quarter of 2017*:

U.S. Large Cap Stocks

14.2%

Emerging Market Stocks

27.8%

U.S. Small Cap Stocks

10.9%

Commodities

-2.9%

U.S. Real Estate

3.6%

U.S. Aggregate Bonds

3.1%

Overseas Stocks

20.0%

International Bonds

8.2%

Economic Outlook

The synchronized global economic recovery continues, providing a solid foundation for corporate earnings and financial assets in general. The multinational Organisation for Economic Co-operation and Development (OECD) Composite Leading Indicator recently hit its highest level since October 2014, indicating growth is broadly distributed across OECD countries. In August, the U.S. Global Manufacturing Purchasing Managers Index (PMI) hit its highest level in over six years and Eurozone and Emerging Market PMIs also rose to multiyear highs. Easing inflationary pressures in emerging markets have allowed numerous emerging-market central banks to lower interest rates this year, which is typically positive for local stock markets. In the United States, GDP growth remains subpar by historical standards but continues to grind along at around a 2% annual rate. Financial conditions have eased over the past year and could suggest capacity for economic growth over the next few quarters at least. It seems that the economic recovery may still have legs.

Despite the U.S. economy’s rather healthy economic indicators, we are overdue for the typical correction. It is worth a reminder that historically, the marked drops at least 5% roughly three times a year and declines 10% or more about once a year. We are at 330 days and counting since the last 5% drop, marking the longest such streak in 26 years. Given that historical reference, investors must be prepared—psychologically and financially—for market dips and drops along the way. They are inevitable and may be unsettling, but remember, they are also temporary.

In contrast, a true bear market in U.S. stocks (a sustained 20%-plus decline) is almost always associated with an economic recession. Recessions, in turn, are typically caused by excessive Fed tightening, usually in response to inflationary pressures, an overheating economy, or financial market excesses. At this moment, none of these scenarios seems imminent in the U.S. or global economy.

However, the debate continues. There is disagreement among economists and strategists as to whether inflationary or deflationary risks should be paramount for the economy at this point in the cycle. Should the Fed policy be dovish or hawkish? As always, there are significant uncertainties when it comes to economic forecasting. Humility and intellectual honesty—knowing what you don’t know—are crucial. There are a range of potential scenarios in our investment decisions that avoid betting heavily on any single macro forecast. As the saying goes, “It’s difficult to make predictions, especially about the future.”

How to Measure the Cost of an Investment Strategy

There are many factors that affect portfolio performance but few have a more predictable impact than the cost of management. Unfortunately, when evaluating various strategies, the average investor is not familiar with the many contributors to total cost. The recent report published by Inside Information called “2017 Planning Profession Fee Survey” summarized factors that everyone should consider and shed light on some of the hidden costs. First, everyone is familiar with the costs associated with the investment management fee. A typical starting management fee is 1% but nearly one-half of advisors charge more than 1% on portfolios with as much as $1MM under management. Another cost consideration is the cost of the underlying investments. Low-cost investments tend to outperform higher-cost investments over time and managing those costs can contribute significantly to performance. Finally, minimizing trading costs (transaction fees) adds to performance. Ultimately, the report showed how similar firms’ total costs can be 3% or more per year. Because Brown Financial Advisory is committed to your performance success, your total cost with us is less than 70% of the firms in the study.

The second quarter proved to be another very strong period for global stock and bond markets but commodities struggled. Larger-cap U.S. stocks surged to 9.3% for the year while international indexes were each up in the mid-teens. Core bonds also delivered solid returns, rising 1.5% for the quarter. But since higher bond prices correspond to lower bond yields, the yield curve “flattened” considerably and the difference between the 10-year and 2-year Treasury yields ended the quarter at close to a post-2008 low. Conversely, commodity prices and energy stocks detracted from the quarter’s returns and remain a weak spot amid a global rally in risky assets due to a 14% decline in oil prices.

The calm, as manifested in low measures of volatility across global markets, was briefly interrupted during the last few days of June. Global stock and bond investors were rattled by comments from the heads of the European Central Bank and the Bank of England suggesting they may be considering the potential end to bond buying policies designed to stimulate markets and a move to raise interest rates, respectively. They were further jolted by Fed Chair Janet Yellen’s statement that “by standard metrics, some asset valuations look high.” In response, bond yields quickly spiked higher, while currency markets saw large swings. Nevertheless, at quarter-end, the S&P 500 was only about 1% below its all-time high.

Here are the broad index returns through the Second Quarter of 2017:

U.S. Large Cap Stocks

9.3%

Emerging Market Stocks

18.4%

U.S. Small Cap Stocks

5.0%

Commodities

-5.3%

U.S. Real Estate

2.7%

U.S. Aggregate Bonds

2.3%

Overseas Stocks

13.8%

International Bonds

5.8%

U.S. stock investors seem a bit complacent now. The VIX index, an indicator of the S&P 500’s expected 30-day volatility, fell to a 23-year low in early May and remained low throughout the quarter. The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty in the U.S. and geopolitical tumult around the world. The extremely low market volatility and high stock market valuations implicitly discount a very rosy economic scenario but economic growth has been noticeably meager so far this year. Interestingly, a U.S. stock market correction (a decline of 10% or more) hasn’t occurred since February 2016 when, on average, they typically occur about once per year.

However, there is room for hope in the most recent economic data. The Atlanta Federal Reserve recently forecasted that the U.S. economy will grow at a 2.9% rate for the year’s third quarter. The unemployment rate is at a near-record low of 4.7% and wages grew at a 2.9% rate in December, the best increase since 2009.

How will the Fed respond to the contradictory data? In past years, the Fed’s actions have repeatedly converged to meet market expectations with a less aggressive rate hiking path than it originally forecasted for itself. The Fed is likely more hawkish at this point in the economic cycle with unemployment down to 4.3% coupled with its expectation that wage, and ultimately, inflationary pressures will emerge. This creates uncertainty and the risk that the Fed will tighten more than the economy and markets can handle. In fact, economist David Rosenberg writes, “If the Fed does what it says it’s going to do, the yield curve will invert sometime next year, with a recession all but an inevitability.”

An inverted Treasury yield curve has preceded the last seven U.S. recessions dating back to the 1960’s. But with global central bank bond purchases still depressing longer-maturity bond yields, this cycle may be different from prior ones. The Bank Credit Analyst sees the risk of a U.S. recession sometime in 2019, after a final burst of growth over the next year. And this being macroeconomics, there are intelligent counter arguments that the Fed is more likely to fall behind the curve (or already has) in tightening monetary policy, meaning a period of higher-than-expected inflation and interest rates will ensue but a Fed-induced recession may be delayed. Whatever the response, it is reasonable to expect additional volatility in the not-too-distant future.

To no one’s surprise, the U.S. stock market has been on a tear. Over the last eight years, the S&P 500 index has returned more than 300% and the tail-end of this run seems to have accelerated the trend. The first quarter of 2017 provided the highest returns for U.S. large-cap stocks since the last three months of 2013. Additionally, the Nasdaq index has booked its 21st record close of the year so far and the index has recorded a whopping 30%-plus rise over the past 14 months, marking the fastest advance since 2006.

In addition to the great domestic stock returns, international investments have been soaring through the start of the year, especially in U.S. dollar terms. European stocks gained 8.6% for the quarter and EAFE’s Pacific ex-Japan Index gained 11.8%. In aggregate, the broad-based EAFE index of companies in developed foreign economies gained 7.4% in the first three months of calendar 2017. Emerging market stocks of less developed countries, as represented by the EAFE EM index, rose an impressive 11.5%.

Here are the broad index returns through the First Quarter of 2017:

U.S. Large Cap Stocks

6.0%

Emerging Market Stocks

11.5%

U.S. Small Cap Stocks

2.5%

Commodities

-2.3%

U.S. Real Estate

1.0%

U.S. Aggregate Bonds

1.0%

Overseas Stocks

7.4%

International Bonds

2.4%

Across a wide range of measures, the global economy is in its best shape in many years. Economic growth in most countries and industries has been accelerating, albeit modestly. In fact, the Global Manufacturing Purchasing Managers Indexes, which have been correlated with global equity returns over time, recently made new multiyear highs in the United States, the eurozone, and China. A quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months. While unexpected macro shocks can occur at any time, the global macroeconomic backdrop offers reason for optimism that many of the reflationary trends that have benefited our portfolios in recent quarters can continue and the likelihood of an imminent U.S. or global economic recession appears low right now. Without a recession, history suggests a bear market in stocks is unlikely.

The European economy seems to have turned an important corner. Last year, for the first time since the 2008–2009 financial crisis, Europe’s economy grew faster than that of the United States. Improving economic growth ultimately leads to better sales growth and gets consumers and corporations to borrow and spend, furthering the cycle. According to the Bank Credit Analyst, private sector credit growth in Europe is up at the fastest rate since the financial crisis. The European Central Bank has revised upward both its inflation and growth projections for 2017–2018.

High current valuations will likely be a headwind to U.S. stock market returns looking out over the next five years but international stocks look attractive. Corporate earnings in the U.S. have not kept pace with the fiery stock market returns of the last few months and valuations have risen. In stark contrast to one another, it appears that European earnings are cyclically depressed while U.S. earnings are near cyclical highs and this relationship does not appear to be adequately reflected in their respective valuations. In Europe, corporate earnings have barely grown since the 2008–2009 financial crisis primarily due to the onset of a regional debt crisis in 2011. Meanwhile, U.S. company earnings have grown strongly, exceeding prior cyclical highs due to historically high profit margins, stock buybacks, and low interest expenses. This results in European stocks appearing to be relatively less expensive than U.S. stocks and more attractive for the long-term. It is impossible to know the precise timing or exactly what catalyst will lead investors to close the gap and begin shifting from U.S. investments to international holdings but history teaches that in time, there will be periods of international stock out-performance.

You know that you are deep into a longstanding bull market when you see things like average pedestrians keeping one eye on the market tickers outside of brokerage houses to see when the Dow Jones Industrial Average has finally breached the 20,000 mark. Who would have thought that there was much good to come when the beginning of 2016 got off to such a rocky start, tumbling 10% in the first two weeks—the worst start to a year since 1930? Nevertheless, the markets eventually bottomed in mid-February and began a long, slow recovery. While the U.S. markets suffered a setback in June when the U.K. decided to leave the Eurozone, and endured another hard bump right after the elections, in the end, we were not disappointed.

The final quarter provided U.S. stock investors with impressive gains. The Wilshire 5000, the broadest measure of U.S. stocks, was up 4.54% in the fourth quarter of 2016 and ended the year up 13.37%. It was also a year to remember for investors in small company stocks. The Russell 2000 Small-Cap Index finished the year up 21.31% after producing an astonishing 11% return in November alone.

Unfortunately, rising U.S. equity prices came at the expense of core bond and international stock returns. The overall U.S. bond market gained 2.65% for the year, but that hid a fourth quarter decline of 3.2% as rising interest rates resulted in the worst quarterly performance for bonds in 35 years. Expectations for rising inflation, along with the Federal Reserve’s December decision to raise interest rates, further contributed to falling bond prices. Emerging Market stocks also declined, falling 4.8% in the final quarter. Nevertheless, the combination of portfolio increases and decreases still resulted in better than average returns across the allocations.

Here are the broad index returns through the Fourth Quarter of 2016:

U.S. Large Cap Stocks

12%

Emerging Market Stocks

11.6%

U.S. Small Cap Stocks

21.3%

Commodities

11.8%

U.S. Real Estate

8.6%

U.S. Aggregate Bonds

2.6%

Overseas Stocks

1.5%

International Bonds

1.9%

Core bonds are likely to continue to struggle over the next market cycle. The combination of the Fed’s plans for three additional interest rate hikes and an incoming presidential administration that promises to significantly increase spending could mean higher debt servicing costs for both consumers and the government (i.e., taxpayers). Placing a greater emphasis on flexible fixed-income strategies is essential to helping the bond portfolio contribute to the overall portfolio return but it cannot completely remedy the issue. Interest rates are still historically low, where the 10-Year Treasury is now yielding 2.45% versus an average over the last 58 years of 6.15%. The result can only mean lower portfolio returns than has been experienced on average in the last 50 years. Fortunately, inflation is also low and net “real” returns (your portfolio return minus inflation) should continue to fall within an acceptable range over a sufficiently long period of time.

Reflecting again on the financial markets’ rocky start to 2016, it is also important to remember how quickly trends can change. While it is unclear how 2017 will play out, since precise inflection points in market performance are impossible to predict, European corporate earnings and eventually stock prices are poised for recovery and valuations in Emerging Market stocks remain favorable. In contrast, U.S. stocks appear somewhat overvalued and have continued to increase despite their historically high price-to-earnings multiples. As interest rates rise, we may see a weakening in the support that the low rates of the past decade have afforded U.S. stock prices. Corporate tax cuts would likely help support higher prices, but over a full market cycle, valuations tend to matter materially while chasing baseless momentum is a recipe for disappointment. Optimistically, short-term market traders seem to be expecting a robust economic stimulus combined with lower taxes and deregulatory policies that would boost the short-term profits of American corporations. But it is helpful to remember that we are entering the ninth year of economic expansion, making this the fourth longest since 1900, and many economists are predicting a recession within the next few years. The best recipe for portfolio success is broad diversification to help ensure the portfolio has upside potential and downside protection across diverse economic outcomes.

One hundred days after the Brexit scare and nine months after the most recent Fed rate hike, the markets once again confounded the instincts of nervous investors and went up instead of down. Last week, Federal Reserve Chairperson Janet Yellen told the world that the U.S. economy is healthy enough to weather a rise in interest rates. Nevertheless, the Fed governors met in September and declined to serve up the first rate hike since last December. That was reassuring news to the Wall Street traders and helped to provide yet another quarter of positive gains in U.S. stocks.

Larger companies were positive but posted the lowest gains. The Russell 1000 large-cap index provided a 4.03% return over the past quarter, with a gain of 7.92% so far this year, while the widely-quoted S&P 500 index of large company stocks posted a gain and is up 7.8% for the year so far. Comparably, the Russell 2000 small-cap index gained 9.05% this quarter, posting an 11.46% gain so far this year.

Comparatively, the U.S. remains a haven of stability in a very messy global investment scene. The broad-based EAFE index of companies in developed foreign economies gained 5.80% in the third quarter but is only up 2.2% for the year. European stocks have lost 2.67% so far in 2016. In contrast, a basket of emerging markets stocks domiciled in less developed countries, as represented by the EAFE EM index, gained 9.03% for the quarter and is sitting on gains of 16.4% for the year so far.

Here are the broad index returns through the Third Quarter of 2016:

U.S. Large Cap Stocks

7.8%

Emerging Market Stocks

16.4%

U.S. Small Cap Stocks

11.5%

Commodities

8.9%

U.S. Real Estate

12.3%

U.S. Aggregate Bonds

5.8%

Overseas Stocks

2.2%

International Bonds

12.5%

What is keeping stock prices high while sentiment appears to be somewhat restrained? No one knows the answer. But a deeper look at the U.S. economy suggests that the economic picture isn’t nearly as gloomy as it is sometimes reported in the press. Economic growth for the second quarter has been revised upwards from 1.1% to 1.4% due to higher corporate spending in general and especially as a result of increasing corporate investments in research and development. America’s trade deficit shrank in August. Consumer spending, which makes up more than two-thirds of U.S. economic activity, rose a robust 4.3% for the quarter, perhaps partly due to higher take-home wages this year.

Meanwhile, if someone had told you five years ago that today’s unemployment rate would be 4.9%, you would have thought they were highly optimistic. But after the economy gained 151,000 more jobs in August, unemployment remained below 5% for the third consecutive month and the trend is downward. At the same time, average hourly earnings for American workers have risen 2.4% so far this year.

Based on their reading of the Treasury yield curve, economists at the Federal Reserve Bank of Cleveland have pegged the chances of a recession this time next year at a low 11.25%. In general, a steep yield curve has been a predictor of strong economic growth, while an inverted one, where short-term rates are higher than longer-term yields, is associated with a looming recession. They predict GDP growth of 1.5% for this election year, which is comfortably ahead of the negative numbers that would signal an economic downturn.

The U.S. returns have been so good for so long that many investors are wondering: why are we bothering with foreign stocks? A recent Forbes column suggested the answer: since 1970 foreign stocks have outperformed domestic stocks almost exactly 50% of the time, meaning the long trend of U.S. out-performance that we have become accustomed to could reverse itself at any time.

No one would dispute that the economic statistics are weak tea leaves for trying to predict the market’s next move. However the slow, steady growth we’ve experienced since 2008 is showing no visible signs of ending and it is hard to find the usual euphoria and reckless investing that normally accompanies a market top and its subsequent collapse of share prices. At the current pace, we might look back on 2016 as another pretty good year to be invested.